The Chinese Way

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This year China is likely to become the third largest games producer in the world. A burst of acquisitions of US games companies by Chinese games companies earlier this year signifies the growing confidence and financial strength of the Chinese games sector and may herald a new phase in the globalisation of the industry.This month I’ll analyse what China’s meteoric rise into the top tier of global games territories means for the Western market.

First, Shanda Games spent $80 million acquiring Mochi Media in January 2010; then came The9’s $20 million majority acquisition of Red 5 Studios in March; and most recently Perfect World took a majority stake in Runic Games in May for $8.4 million. They represent the first three transactions in the western games market by a sector that barely existed five years ago.

Mimicking recent global economic trends, Chinese games companies have prospered over the last few years whilst North America and Europe have suffered ever-declining sales and their largest indigenous publishers have struggled to avoid falling revenues and losses. China’s success has been achieved without material sales outside of the Asian continent. This minimal global influence is clearly not going to last and these recent US transactions highlight one potential route into the Western market.

Crowded House

The Chinese online games market is expected to grow around 30 per cent this year to reach $4.6bn and, whilst the rate of growth may slow down, it still has considerable room for long-term expansion.

China already houses the largest internet user-base in the world at around 400 million, but this still represents less than a third of the population, in comparison to around 75-85 per cent for most Western countries.It has an increasingly tech literate, wealthy and middle class populace benefiting from a buoyant economy and rampant entrepreneurialism. Both the number but also the monthly and lifetime value of Chinese gamers is far from peaking.

From this fertile primordial games market has arisen hundreds of indigenous games ventures, around a dozen of which will generate over $100 million in sales this year. The largest – online and mobile giant Tencent’s games business – recorded $300 million in sales during its most recent quarter, overtaking THQ, Take 2 and Ubisoft.

The next two, Netease and Shanda Games, are expected to reach $800 million and $700m million turnovers respectively in 2010. More impressive is the fact that almost all of these companies are not only profitable but massively so. 50 per cent-plus net profit margins are not unheard of. In addition to throwing off sizeable amounts of cash, many of these businesses have sought to bolster their balance sheets with IPOs and additional fund raising. Giant Interactive, a mid-tier publisher with just $200 million in expected sales in 2010, currently has some $700 million in liquid assets – more than the combined cash reserves of THQ, Take 2 and Ubisoft – whilst the top-seven have some $5.2 billion to spend in aggregate. The $108.4 million spent so far would appear, therefore, a drop in the ocean. There is clearly the capability, but is there the appetite to make more purchases in the West?

An Aquiring Taste

The answer, for me, is a conditional yes. The West represents a huge, mature market whose player base is considerably more valuable than those found in China. However, unless there is a radical change in direction, Chinese companies are only going to be interested in network games businesses in the West; buying a traditional games developer or publisher would result in unwelcome earnings dilution, lumber them with business practices, technologies and infrastructure that are both alien and largely irrelevant to them.

All three acquisitions this year were of network games ventures that complement the Chinese companies’ businesses.

The Chinese companies will primarily seek to apply their capital and business know-how to Western-developed network games, although we also expect more Chinese publishers to follow Korean publishers’ leads and establish North American and European operations to exploit their existing Chinese-developed IP.

I don’t believe Western expansion will be an investment priority for several years given the rate at which the Chinese and pan-Asian markets are growing. The Chinese hordes are amassing but there will be no invasion just yet.

However, I expect to see sporadic additional acquisitions being made in the West as the Chinese flex their financial muscles, and use opportunistic acquisitions and investments to ‘learn’ the Western market and build a foundation for future operations.

In the longer term, the question of whether China will become significant investors in the Western games market is, in my mind, more a case of when, rather than if.

Nick Gibson is a director at Games Investor Consulting, providing research, strategy consulting and corporate finance services to the games, media and finance industries.www.gamesinvestor.com